A Tale of Two Crises: Korea’s Experience with External Debt Management Paper Prepared by Professor Yung Chul Park Seoul National University UNCTAD Expert Meeting Debt Sustainability and Development Strategies

Korea’s Experience Small and large financial crises: ; ; ; ; In each case the crises were preceded by:  An investment boom  A growing current account deficit in proportion to GDP  A real effective appreciation of the currency

Developments leading up to the crisis Export promotion strategy  Investment boom Dramatic rise in inflation in 1980 Appreciation of the real effective exchange rate Slowing of growth in 1979

Additional Developments Oil crisis 1979  Deterioration of Terms of trade Assassination of President Park in 1979 Deep Recession in 1980  Contraction of investment  Poor Harvest Increase in current account deficit

Crisis Deep Recession Large current account imbalance Crisis in the informal credit market Total debt as a proportion of GDP rose by more than 10 percent in 1980

Crisis Response and Management Devaluation of the won vis-à-vis the US dollar (27 percent in 1980) Move to a managed float Growth-first strategy  Spending out strategy  Expansionary fiscal policy  High growth of M2 and M3

Recovery and Shift to Stabilization Inflation begins to subside in 1981 Current account deficit shrank to 3.3 percent of GDP by 1982 Resumption of double digit growth in 1983 Shift to stabilization policies  Reversal of monetary and fiscal policies Total external debt remained over 47 percent of GDP  Heavily laden with short term loans

Capital Account Crisis

Investment Boom prior to the Crisis Steady economic growth ( ) Strengthening of the yen Financial liberalization and market opening Movement to foreign countries as foreign direct investors High accumulation of foreign debt of domestic firms

Bursting of the Investment Bubble Depreciation of the yen (Q3 1995) Deterioration Korea’s of terms of trade Real effective exchange rate appreciation (Q3 1995) Slowing of the economy in second half of 1996  Industrial groups slow to adjusting investment and output Rising inventories Accumulation of debt  Commercial Banks less willing to meet credit needs

Factors contributing to financial market collapse 1997 Slowdown of export growth Deterioration of terms of trade Soaring levels of corporate bankruptcies Rapid rise in non-performing loans of financial institutions (Dec 1996-June 1997)

Additional factors contributing to collapse Pending presidential elections (Dec 1997)  Political uncertainties prompt capital flight Unclear exchange rate policy Defense of the won under pressure to depreciate  Fall in the Bank of Korea’s reserve holdings Repeated lowering of sovereign credit rating  Contributed to further the worsening of market sentiment and foreign exchange rate depreciation

Management and Recovery of Crisis Government reform package (19 Nov. 1997) IMF Bailout (3 Dec 1997)  Package $21 billion  Conditionality  Response to bailout package Emergency financing program (24 Dec 1997)  Additional funds ($10 billion)  Government guarantee on private debt Macroeconomic Policy Adjustments  Initial tightening of monetary and fiscal policy  The consequential increase in interest rates contributed to widespread bankruptcies  Reversal of fiscal and monetary policies in the face of a deeper recession to more accommodative stance.

Strong contraction of GDP in 1998 to -6.9 percent growth Rise in inflation (7.5 percent) Strong depreciation of the won vis-à-vis the dollar Rapid Recovery  Expansion of growth by 9.5 percent in 1999  Current account surplus in 1998 Large increase in net exports Decline in import demand Crisis

Rapid Recovery Higher level of openness fueled recovery:  Large depreciation  Large trade sector and export orientation Flexibility of labor market  Wage adjustments  Reallocation of resources from non-tradeables to the tradeables sector Strong global economy  Improvement in terms of trade in 1999  Appreciation of the yen

Similarities across crises Crises were in part precipitated by an investment boom financed by foreign borrowing. Rapid recovery Similar ratios of external debt to GDP Rigid foreign exchange rate systems exacerbated the crises Economic fundamentals Aggressive export promotion policies

Differences between crises First case  Capital account transactions were tightly controlled  No capital flight  Continued willingness to finance the CA by international financial market  Spend-out policy adopted Expansionary monetary and fiscal policy Second case  Capital account deregulation and freer movement of capital  Capital flight  IMF package Tight monetary and fiscal policy in concert with devaluation of the exchange rate

Policy response  (expansionary/contractionary) Economic environments  Economic liberalization  Market deregulation Differences between crises